Removing the Impact of Foreign Exchange Translation from Financial Analysis
Author: Andy Kaempfe
The continued expansion of the global economy no longer limits the complexities of foreign currency to multibillion-dollar conglomerates. Because both middle- and lower-middle market companies are trading beyond domestic borders, one must understand both the translation and transaction impacts of foreign currency to evaluate the underlying entity’s true economic performance.
Financial Statement Translation Impact
Accounting guidelines (including generally accepted accounting principles in the United States, or U.S. GAAP) require companies with foreign operations to translate the results of operations of foreign entities from their functional (or local) currencies to a single reporting currency. Typically, a weighted average exchange rate is used to translate the results of operations for the reporting period. However, when analyzing a company’s financial trends over multiple periods, significant shifts in currency exchange rates can have a dramatic effect on the company’s revenue and profit trends. Note: Working capital also can be affected, but this article focuses on income statement impact.
Consider the impact of the U.S. dollar over the past several years. The dollar has risen sharply against many of the United States’ major trading partners’ currencies during the last five years. The chart below illustrates the trend in the U.S. dollar-to-euro exchange rate over this period:
An analysis of a company with operations in a single country—even a foreign country—wouldn’t be significantly skewed by changing exchange rates if the operations are analyzed in the local currency. However, for companies with significant operations in multiple countries, fluctuating exchange rates can considerably affect financial statement trends.
The simple example below further illustrates this point: Company ABC has operations in the U.S. (USD) and Europe (euro). For simplicity’s sake, sales are flat in each currency over the last five years. However, trends in the exchange rate between the U.S. dollar and euro result in increased volatility. In USD, it appears earnings are decreasing, but in euros, earnings appear to be increasing. What’s the correct answer?
To evaluate historical results without the impact of foreign currency translation, consider a constant currency analysis that converts all periods to a constant rate (typically, the rate at the beginning or end of the analysis period). This enables a reader to evaluate the actual change in earnings without the swings that accompany the analysis of U.S. GAAP financials. In this case, the constant currency analysis would result in flat earnings, since that’s the underlying trend.
Let’s consider another example: Could foreign currency fluctuations be covering up a trend that would otherwise raise alarms? For this example, the assumption is that the parent company is in Europe, so all financial statements are converted to the euro. If all assumptions are the same as the previous example except for a 5 percent annual decrease in U.S. earnings, an annual currency conversion actually would cover up much of this decrease. In fact, total 2015 earnings in this example (in euros) are slightly higher than 2011. However, a constant currency analysis would uncover the underlying decreases in U.S. earnings.
Here’s one last example similar to the previous one: What if the foreign currency trends caused a company to actually appear worse off than it really was? This would especially be an issue from the sell side of a transaction where the seller wants to maximize the company's value. For this example, the assumption is that the parent company is in the U.S., so all financial statements are converted to the U.S. dollar. If U.S. earnings were flat, but European operations increased at a rate below currency changes, 2015 converted earnings would be lower than 2011. However, using a constant currency analysis could uncover the underlying increases in European earnings.
Transaction Foreign Exchange Gains & Losses
The constant currency analysis described above strictly deals with the translation of subsidiary financial information to the parent company’s currency. However, there can be other foreign currency gains and losses to consider when evaluating a company’s financial statement trends.
Most companies that either sell to or buy from foreign entities under a different currency have a transaction gain or loss recognized in the income statement. This gain or loss results from the exchange rate changing from the time of the sale or purchase to the time when cash actually changes hands. This can have either a positive or negative effect on a company, depending on which currency the transaction is designated in and which direction the exchange rate moves.
In a merger, acquisition or divestiture, these foreign exchange gains and losses may have subjective valuation treatment. Although these gains or losses likely will continue to occur as long as the company continues to transact in foreign currencies, the impact may be considered nonoperational or separately evaluated from the core operations.
Many companies with significant foreign operations also may employ hedging techniques to mitigate the risk for both foreign currency translation and transaction impact on the financial statements. Under a perfected hedging arrangement, a company would be protected from changes in foreign currency exchange rates. Notwithstanding, hedging strategies can be extremely complex and, at times, ineffective.
Financial statement trends for companies with foreign subsidiaries can’t always be taken at face value. Changes in foreign currency exchange rates can mask both concerning and encouraging trends in foreign subsidiaries. Therefore, understanding the overall trends of a company’s foreign operations through a constant currency analysis can portray a different picture than U.S. GAAP financial statements.
For more information on foreign entity due diligence, contact a member of the BKD Transaction Services team.